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Inventory management is a critical aspect of any business, ensuring the smooth flow of goods from suppliers to customers. However, managing inventory comes with various risks that can significantly impact a company's operations and profitability.

Inventory risks come in various forms, each with its unique set of challenges and implications. From demand variability and supplier reliability to obsolescence and shrinkage, these risks can stem from internal processes, external market conditions, or a combination of both. The impacts are far-reaching, often resulting in stockouts, excess inventory, increased carrying costs, and, ultimately, a detrimental effect on the bottom line.

Addressing these risks requires a proactive approach and a thorough understanding of their root causes. In this blog, we will explore the meaning of inventory risks, the different types of inventory risks, and their potential impacts on your business.

What is Inventory Risk? Understanding it through a Case Study

Inventory risk refers to the potential financial loss a business may face due to holding inventory that becomes obsolete, damaged, or unsellable. This risk arises from factors such as market demand fluctuations, changes in consumer preferences, technological advancements, and supply chain disruptions. When inventory is not sold within a certain period, it can lead to increased storage costs, insurance expenses, and potential write-downs or write-offs, negatively impacting a company's profitability and cash flow.

In 2020, Target Corporation, a retail giant, experienced significant risk due to improper inventory management. This was during the outbreak of corona, when the company had overstocked seasonal items like holiday merchandise. This led to an excess of unsold inventory, which not only tied up capital but also required heavy markdowns to clear the shelves after the season ended.

As a result, Target reported a drop in profitability for that fiscal year, with margins squeezed due to increased promotional costs and lower-than-expected sales. The overstocking issue also strained relationships with suppliers and affected future forecasting accuracy.

9 Common Types of Inventory Risks in Supply Chain

When managing inventory, businesses face several types of risks that can impact their operations and profitability. Here are common types of inventory stock risks in the supply chain:

1. Forecasting Errors

Forecasting errors in supply chain management are common types of inventory risk. It occurs when the projected demand for products or materials differs significantly from the actual demand. These errors can arise due to inaccurate data, inadequate forecasting models, or unforeseen market changes, leading to suboptimal inventory levels and operational inefficiencies.

Impacts of Forecasting Errors in Inventory Management:

Excess Inventory: Overestimating demand results in surplus stock, tying up capital and warehouse space.
Stockouts: Underestimating demand leads to insufficient inventory, causing lost sales and customer dissatisfaction.
Increased Costs: Inaccurate forecasts may necessitate expedited shipments or last-minute production adjustments, increasing costs.
Customer Dissatisfaction: Fluctuating availability due to forecasting errors can undermine customer trust and loyalty, impacting brand reputation negatively.

2. Stockouts

Stockouts are one of the types of inventory risks which occur when a company runs out of a particular product and is unable to meet customer demand. This can stem from inaccurate demand forecasting, supply chain disruptions, or delays in production or delivery. Factors like seasonal fluctuations, sudden spikes in demand, or logistical issues can exacerbate stockouts.

Impacts of Stockouts in Inventory Management:

Lost Revenue and Market Share: Stockouts result in missed sales opportunities, leading to revenue loss and potential customer defection to competitors.
Decreased Customer Loyalty: Unfulfilled orders due to stockouts can erode customer trust and loyalty, impacting long-term relationships.
Operational Disruptions: Stockouts disrupt production schedules and order fulfilment processes, increasing operational costs and complexity.

preventable vs Unpreventable Inventory Risks — Image 1. Managing Inventory Risks: What You Can and Can't Control

3. Overstocking

Overstocking is one of the types of inventory frauds occurs when a company holds excess inventory beyond current demand levels. It often results from inaccurate demand forecasting, promotional misfires, or overzealous purchasing. Overstocking ties up capital in unsold goods, leading to increased storage costs, risk of obsolescence, and potential write-offs.

Impacts of Overstocking on Inventory Management:

Increased Holding Costs: Excess inventory ties up capital in storage costs, reducing profitability and cash flow.
Risk of Obsolescence: Overstocked items are at risk of becoming obsolete, leading to inventory write-offs and financial losses.
Reduced Warehouse Efficiency: Overstocking can overcrowd warehouses, making it harder to manage and locate items efficiently, increasing labor and storage costs.

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As reported by Forbes, on average, the second largest expense for businesses after labor costs is inventory, comprising approximately 25% to 35% of a business’s total budget.

4. Obsolescence

Obsolescence in inventory refers to goods that become outdated or unusable before they can be sold. This can occur due to technological advancements, changes in consumer preferences, or regulatory changes. Products may also become obsolete due to new models or versions being introduced, rendering older inventory less desirable or even unsellable.

Impacts of Obsolescence on Inventory Management:

Financial Losses: Obsolete inventory ties up capital that could be used elsewhere, leading to reduced profitability and cash flow.
Storage Costs: Keeping obsolete items incurs ongoing storage expenses, further reducing overall profitability.
Impaired Forecasting: Obsolescence distorts demand patterns, making accurate forecasting challenging and potentially leading to more inventory management issues.

5. Spoilage

Spoilage occurs when perishable goods, such as food items or pharmaceuticals, deteriorate beyond usability before they can be sold or used. Factors contributing to spoilage include inadequate storage conditions, improper handling during transportation, or extended shelf life.

Impacts of Spoilage on Inventory Management:

Financial Losses: Spoiled inventory leads to direct financial losses due to unusable products.
Reputation Damage: Consistently encountering spoiled goods can damage a company's reputation for quality and reliability.
Operational Disruptions: Managing and disposing of spoiled inventory disrupts normal operations and can increase costs.‍

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What is the main purpose of inventory management?

The main purpose of inventory management is to ensure that a business maintains optimal inventory levels to meet customer demand without overstocking or understocking, thereby minimizing costs and maximizing efficiency, profitability, and customer satisfaction.

Read our blog, ‘7 Major Inventory Management Techniques for Business Success,’ to learn effective inventory management techniques.

6. Theft

Theft is a type of inventory risk in inventory audit which refers to the unauthorized or illegal removal of goods from a company's premises or supply chain. It can occur internally, involving employees or contractors, or externally through burglary or fraudulent activities.

Impacts of Theft in Inventory Management:

Financial Losses: Theft results in direct financial losses for the company, impacting profitability.
Operational Disruptions: Dealing with theft disrupts normal operations and may require additional security measures.
Inventory Accuracy: Theft skews inventory records, leading to inaccuracies that can affect planning and decision-making.

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As per Fortune Business Insights, the global market for inventory management software reached a valuation of $2.13 billion in 2023 and is anticipated to increase from $2.31 billion in 2024 to approximately $4.84 billion by 2032.

7. Damage

Damage to inventory is a type of inventory risk that occurs when goods are physically harmed or impaired, rendering them unsellable or less valuable. This can happen during transportation, storage, handling, or even within the production process. Common causes include mishandling, accidents, environmental factors like temperature or humidity, and inadequate packaging.

Impacts of Damage on Inventory Management:

Financial Losses: Damaged inventory results in direct financial losses due to reduced or unusable products.
Customer Satisfaction: Damaged goods can lead to dissatisfaction among customers, impacting relationships and loyalty.
Operational Delays: Dealing with damaged inventory disrupts normal operations, requiring additional handling and potentially delaying order fulfilment.

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Top Inventory Risk Indicators and Metrics — Image 2. Essential Metrics for Identifying Inventory Risk Factors

8. Supplier Reliability

Supplier Reliability refers to the consistency and dependability of suppliers in delivering goods as promised, which is crucial for maintaining smooth operations in supply chains. This risk arises when suppliers fail to meet agreed-upon quality, quantity, or timing requirements. Reasons for supplier unreliability include poor communication, inadequate capacity planning, or disruptions such as natural disasters or economic crises.

Impacts of Supplier Reliability on Inventory Management:

Stockouts: Unreliable suppliers can lead to frequent stockouts, affecting product availability and customer satisfaction.
Increased Costs: Finding alternative suppliers or expedited shipping options due to unreliable suppliers can increase procurement costs.
Production Delays: Delays in receiving goods from unreliable suppliers can disrupt production schedules, impacting overall operational efficiency.

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Case Study:

Toyota, a global automotive giant, faced significant inventory risks in 2011 due to the Great East Japan Earthquake and the subsequent tsunami. These events disrupted the supply chain, leading to critical shortages of parts and halting production across various plants.
Toyota's just-in-time (JIT) inventory system, which minimizes inventory costs by receiving goods only as they are needed, was heavily impacted. The sudden disruption highlighted the vulnerability of relying on a tightly controlled supply chain without sufficient inventory buffers.
n response, Toyota implemented several strategic changes. They diversified their supplier base to reduce dependency on single sources. Additionally, Toyota increased its inventory of critical components, creating a buffer to handle future disruptions. The company also improved its supply chain visibility through enhanced monitoring systems, allowing for better risk assessment and quicker response to potential issues.

9. Demand Fluctuations

Demand Fluctuations are a major type of inventory risk that entails unpredictable changes in consumer or market demand, posing significant risks in inventory management. These fluctuations can stem from seasonal trends, economic shifts, consumer behaviour changes, or sudden market disruptions.

Impacts of Demand Fluctuations in Inventory Management:

Inventory Imbalance: Fluctuating demand can lead to either excess inventory or stockouts, challenging inventory management.
Forecasting Challenges: Rapid demand shifts make accurate forecasting difficult, leading to inventory planning errors.
Cost Variability: Adjusting inventory levels to match fluctuating demand can increase storage costs or result in lost sales opportunities.

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What are the different types of inventory policies?

Just-In-Time (JIT): Inventory is ordered and received only as needed for production, minimizing holding costs and reducing waste.
Economic Order Quantity (EOQ): Determines the optimal order quantity to minimize total inventory costs, including ordering and holding expenses.
ABC Analysis: Classifies inventory into three categories (A, B, C) based on importance and value, focusing resources on high-value items.
Safety Stock: Maintains a buffer of extra inventory to prevent stockouts due to demand variability or supply delays.
Vendor-Managed Inventory (VMI): Suppliers manage and replenish inventory levels based on agreed-upon criteria, reducing the buyer's inventory management burden.

Conclusion

Implementing appropriate techniques and technologies is crucial to managing several types of inventory risks effectively. Technologies such as RFID tracking, inventory optimization software, and AI-driven demand forecasting enhance efficiency and mitigate these risks. However, it can be challenging for businesses to manage these techniques in-house due to high initial costs, the need for specialized expertise, and ongoing maintenance requirements.

Consequently, many businesses are preferring outsourcing to specialized firms. These firms offer the required expertise, scalability, and cost-efficiency. Outsourcing partners use the latest techniques to manage inventory, control risks, and conduct regular audits to keep stocks in control.

Invensis is a leading inventory management services provider with more than 24 years of experience. We bank on streamlined processes, advanced technologies and the experience of our team to manage inventories of businesses of several types. With our scalable team, we adjust ourselves to control the inventory of your business' inventory as per the requirements. Contact us today to effectively mitigate various types of inventory risks in your business.

Frequently Asked Questions

1. What type of risk is inventory risk?

Inventory risk refers to the potential financial losses or operational disruptions arising from fluctuations in inventory levels. It encompasses risks such as overstocking, leading to storage costs and obsolescence, or understocking, resulting in lost sales and customer dissatisfaction.

2. What are the 4 types of inventory classifications?

The four main types of inventory classifications are:

Raw Materials: Items used in production processes before they become part of the final product.
Work-in-Progress (WIP): Goods that are in the process of being manufactured but are not yet completed.
Finished Goods: Products that are ready for sale to customers.‍
MRO Goods (Maintenance, Repair, and Operating Supplies): Materials and supplies used in the production process or for maintaining operations but not directly incorporated into the final product.

3. What are the 3 major types of inventory strategies?

The three major types of inventory strategies are:

Just-in-Time (JIT): A strategy aimed at minimizing inventory levels by receiving goods only when needed for production or sale, reducing holding costs and waste.
Safety Stock: Maintaining extra inventory beyond immediate needs to buffer against unexpected demand fluctuations, supply chain delays, or other uncertainties.
ABC Analysis: Classifying inventory into categories based on value or importance (e.g., A for high-value items, B for moderate, and C for low), allowing prioritization of management efforts and resources.

4. What are the risks of the inventory cycle?

The inventory cycle poses risks such as overstocking, leading to storage costs and obsolescence, or understocking, causing stockouts and missed sales. Poor forecasting can result in inaccurate demand projections, impacting cash flow and operational efficiency. Additionally, theft and damage during storage or transit can lead to financial losses and customer dissatisfaction, necessitating robust risk management strategies.

Simmons Bennett

Simmons is an accomplished professional in order management, leveraging his extensive knowledge and expertise to deliver exceptional writing. With years of experience under his belt, he adeptly handles the complexities of order processing and fulfillment. Simmons' proficiency extends across diverse industries, consistently offering valuable insights and implementing efficient solutions. He excels in inventory management, order tracking, and optimizing logistics for seamless operations. Recognized as a prominent writer in the order management space, Simmons delivers concise and actionable guidance, empowering businesses to streamline their order processes and elevate customer satisfaction to new heights.